Filed: September 12, 2006
EB-2005-0501
Exhibit C1
Tab 7
Schedule 1
Page 1 of 7
1
PAYMENTS IN LIEU OF CORPORATE INCOME TAXES
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Under the Electricity Act, 1998, Hydro One Networks Inc. (“Networks”) is required to
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make payments in lieu of corporate income taxes (PILS) relating to taxable income earned
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by its transmission business. The Ontario Energy Board (“OEB”) has directed that the
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taxes payable method should also be used for regulatory purposes (2006 EDR Handbook
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section 7.1 “OEB 2006 regulatory taxes expense methodology”).
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Under the taxes payable method, no provision is made for future income taxes that result
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from timing differences between the tax basis of assets and liabilities and their carrying
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amounts for accounting purposes. Accordingly, the taxes payable method will result in the
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PILS income tax payable being different than the amount that would have been recorded,
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had the combined Canadian Federal and Ontario statutory income tax rate been applied to
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the regulatory net income before tax. When unrecorded future income taxes become
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payable, it is expected that they will be included in the rates approved by the OEB and
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recovered from customers at that time.
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PILS installments are remitted by Networks to OEFC at the end of each month. Any
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balance owing at the end of the year is required to be paid by February 28th of the
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following year.
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In the absence of an Electricity Transmission Handbook, the 2007 and 2008 Hydro One
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transmission regulatory tax calculations have been prepared consistent with the approach
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found in the 2006 EDR Handbook and the 2006 EDR Tax Model, as this approach reflects
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the tax payable relating to taxable income earned by the transmission business.
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Filed: September 12, 2006
EB-2005-0501
Exhibit C1
Tab 7
Schedule 1
Page 2 of 7
1
Income Tax Rate (Federal and Ontario):
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A combined rate of 36.12% has been used for 2007 (Federal 22.12% and Ontario 14%)
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and 34.5% for 2008 (Federal 20.5% and Ontario 14%). Prior to 2008, a 36.12% combined
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Federal and Ontario income tax rate had been in effect from 2004 (2003 36.62%).
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Reconciliation between Regulatory Net Income Before Tax and Taxable Income:
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A reconciliation between the regulatory net income before tax (NIBT) and taxable income
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for the forecast years 2007 and 2008 is provided in Exhibit C2, Tab 6, Schedule 1. This
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schedule contains the income tax component of the PILS computation. It also shows how
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the taxable income is computed by making adjustments to the regulatory NIBT for items
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such as depreciation, capital cost allowance (CCA) etc.
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A reconciliation between the accounting NIBT and taxable income for the historical years
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is provided in Exhibit C2, Tab 6, Schedule 1.
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In order to make it easier for parties to follow the above reconciliations, we have placed
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the adjustments made to regulatory NIBT to arrive at taxable income into the following
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five categories:
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1) Recurring items that must be added (deducted) because they have been included in the
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OM&A expenses in arriving at the revenue requirement or for which appropriate tax
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adjustments are made (e.g. depreciation vs. CCA);
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2) Deferral accounts not included in the revenue requirement;
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3) Reversal of accounting adjustments not included in the revenue requirement;
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4) Recurring items not in the revenue requirement; and
Filed: September 12, 2006
EB-2005-0501
Exhibit C1
Tab 7
Schedule 1
Page 3 of 7
1
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5) Items where the impact is immaterial in total, and as such, have not been included in
our business plan (applicable to forecast years only).
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4
Overview of Process to Arrive at Taxable Income:
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The starting point for the computation of Networks Transmission taxable income is the
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NIBT as shown on the utility's income statement for the year. Since the NIBT is prepared
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using Canadian generally accepted accounting principles and taxable income is computed
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using the relevant tax legislation, interpretations and assessing practices, there are
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typically many adjustments that are made to the NIBT to arrive at taxable income.
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Essentially, the NIBT is increased by amounts that are not deductible for tax purposes.
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This includes items such as depreciation, contingent liabilities, accounting losses,
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accounting provisions such as OPEB etc. and revenue that has been received but not
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recognized for accounting purposes (e.g. TX export revenue). On the other hand, the
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NIBT is reduced by amounts that are deductible for tax purposes but have not been
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deducted in computing NIBT. This includes items such as CCA, the deductible portion of
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capitalized overhead, expenses incurred for which a deferral account has been set up on
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the balance sheet rather than being deducted through the income statement, accounting
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gains, OPEB payments etc.
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Consequently, it is imperative that the NIBT be adjusted for amounts that have been
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included (or deducted) for accounting purposes that are not income (or deductible) for tax
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return purposes. This is a key point in comparing the historical years tax return data to
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that computed for the forecast years, since the tax return NIBT has been increased (or
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reduced) by amounts that have not been added (or deducted) in computing the regulatory
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NIBT (e.g. contingent liabilities, accounting gains, capitalized interest). That is, for
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forecast years 2007 and 2008, only differences between the tax and accounting rules
Filed: September 12, 2006
EB-2005-0501
Exhibit C1
Tab 7
Schedule 1
Page 4 of 7
1
related to costs included in either the regulatory revenue requirement or rate base
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(e.g. CCA, capitalized overhead) are adjusted for in arriving at taxable income.
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Tax Treatment of Deferral Accounts (Regulatory Assets and Liabilities):
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Deferral accounts are typically recognized by utilities (i.e. on their balance sheet) for
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foregone revenue or for expenses that have been incurred for which recovery will be
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sought from ratepayers through future rates.
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determined by the OEB through a rate rider process.
Disposition of the deferral accounts is
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For example, assuming that a $100 expense is incurred, the utility will be allowed to
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deduct the $100 in computing taxable income for the year in which the expense has been
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incurred. If the OEB subsequently approves recovery of these expenses over a four year
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period through a rate rider, the income will be included in computing taxable income for
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the year in which it is billed to ratepayers. The net result is that the utility has recovered
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the $100 cost although the income/expense has been taxed or deducted in different years.
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Year 1 Year 2
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Income (deduction)
(100)
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Tax refund (payable)
35
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Cash inflow (outflow) (65)
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Year 3
Year 4
Year 5
CUM
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25
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nil
(8.75)
(8.75)
(8.75)
(8.75)
nil
16.25
16.25
16.25
16.25
nil
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Therefore, deferral accounts have not been included in computing tax payable for
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purposes of the revenue requirement since the tax benefit has or will be obtained through
Filed: September 12, 2006
EB-2005-0501
Exhibit C1
Tab 7
Schedule 1
Page 5 of 7
1
the tax system. It should be noted that this conclusion is consistent with the "2006 EDR
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Handbook Report of the Board" issued May 11, 2005 (Page 61) that stated as follows:
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"A PILS or tax provision is not needed for the recovery of deferred regulatory
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asset costs, because the distributors have deducted, or will deduct, these costs in
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calculating taxable income in their returns.
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treatment."
The Handbook will reflect this
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Contingent Liabilities/Accounting Reserves:
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Where an accounting provision is recognized for certain contingent costs that the utility
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may have to incur in the future (e.g. obsolescence provisions, lawsuits, staff reductions,
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etc.), the provision will reduce the NIBT of the utility. In each subsequent year, the
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balance for the contingent liability/accounting reserve is reviewed by the utility for
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reasonableness based upon the information available at that time. The balance may be
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adjusted upward or downward with NIBT either decreasing or increasing respectively.
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However, for tax purposes, a contingent liability or accounting reserve is not deductible.
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Rather, the amount will only be deductible (or capitalized) in computing taxable income
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for the taxation year in which the obligation has actually been settled. Therefore, to the
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extent that the current year NIBT has been increased (or decreased) by the contingent
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liability or accounting reserve provision, the NIBT must be adjusted to reverse the
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increase (or decrease) in computing taxable income.
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It is not necessary to adjust the 2007 and 2008 NIBT for contingent liabilities in
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computing taxable income since no changes were forecast in those contingent liability
Updated: February 16, 2007
EB-2005-0501
Exhibit C1
Tab 7
Schedule 1
Page 6 of 7
1
balances reflected in 2007 and 2008 respectively.
Therefore, such amounts are not
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included in the tax computation for purposes of the revenue requirement.
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The $7 million deduction in the 2003 tax return ($1 million and $2 million deduction for
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2004 and 2005 respectively) for the contingent liabilities movement Exhibit C2, Tab 6,
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Schedule 1, line 22, is simply reversing the accounting income inclusion resulting from
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the net reduction in the various contingent liabilities balance and/or deducting the actual
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payments, since as stated above, contingent liabilities are not relevant in computing
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taxable income.
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Class 47, Transmission Assets 8% CCA rate:
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In deriving the 2007 and 2008 utility income taxes, for asset additions after February 22,
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2005, Hydro One Transmission has reflected the enacted change in CCA rate of 8% for
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Class 47 (previously Class 1, 4%), applicable to new assets acquired subsequent to that
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date.
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Federal Large Corporation Tax ("LCT"):
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The LCT has been eliminated effective January 1, 2006, accordingly, for 2007 and 2008
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no LCT component has been included in our PILS computation on Exhibit C2, Tab 6,
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Schedule 1.
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Filed: September 12, 2006
EB-2005-0501
Exhibit C1
Tab 7
Schedule 1
Page 7 of 7
1
Ontario Capital Tax:
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Networks pays an Ontario capital tax on its taxable capital as defined by the Corporations
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Tax Act (Ontario). However, for regulatory purposes, it recovers capital tax that is
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computed by reference to its rate base net of the applicable Ontario exemption, as directed
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by the OEB. Please refer to Exhibit C2, Tab 4, Schedule 1, “Capital Taxes” for the
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calculation of the Ontario capital tax. For the forecast years, the Ontario capital tax rate
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used is the rate proposed in the March 23, 2006 Ontario budget of 0.285%. This compares
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to a capital tax rate of 0.3% applicable to the historical and bridge years.
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The Ontario exemption is allocated amongst the related regulated entities, based on rate
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base.
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